One of your colleagues has given you constant dollar information about the antic
ID: 2620769 • Letter: O
Question
One of your colleagues has given you constant dollar information about the anticipated savings cash flow from a modernization project that your team is evaluating. This project will last 3 years. Your colleague believes the savings at the end of the first year will be $30,000 and it will increase by $1000 each of the following years 2 and 3.
Your company requires economic evaluations be calculated using actual dollars for all cash flows. You know that the general inflation rate is 4% and the inflation-free interest rate is 6%.
What is the present worth of the savings cash flows using actual dollar analysis? (Assume annual compounding for the interest rate you use for the present worth calculation.)
Explanation / Answer
Inflation rate = 4%
Inflation free interest rate = 6%
Discount rate = 4% + 6%
= 10%
Discount rate for cash flow is 10%.
Cash flow in year 1 is $30,000, cash flow in year 2 is $31,000 and cash flow in year 3 is $32,000.
Present value of cash flow = [$30,000 / (1 +10%)] + [$31,000 / (1 +10%) ^ 2] + [$32,000 / (1 +10%) ^ 3]
= ($30,000 / 1.10) + ($31,000 / 1.21) + ($32,000 / 1.331)
= $27,272,73 + $25,619,83 + $24,042.07
= $76,934.64
Present value of cash flow is $76,934.64.
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